Markets are driven by conventional wisdom; and the conventional wisdom about the Indian markets — at least till this week — was that they were ‘decoupled’ from events in the rest of the world, preserved both by what remains of our former foreign exchange regime and by the explosive growth in our consumption. However, as Galbraith pointed out almost 50 years ago, the march of events tends to ignore the assumptions of conventional wisdom. Now most eagle-eyed analysts are hastily denouncing decoupling as a myth, and its defenders are tempering their enthusiasms with long-overdue caution. Even Commerce Minister Kamal Nath, surrounded by decoupling enthusiasts at Davos on Wednesday, was careful to say that “no economy can totally decouple itself from the US”, though he did manage to mention that India is better placed than China to do so.

Most believe that the American crisis was caused by overconfidence about growth combined with sophisticated — or, at any rate, complicated — financial instruments in real estate markets, which permitted financial intermediaries to package and sell high-risk house loans packaged as low-risk securities. Consequently, objective evaluation of the risks of individual loans suffered and the actual risk of any investment in real estate-backed securities became near-impossible to calculate.

So well is this understood now that the Democratic candidates for president have universally called for greater regulation of mortgage markets in the US. In their debate last week in Nevada, they were in agreement about this, disagreeing only about who called for it first. (The Republican candidates, true to form, seem to think that a tax cut will solve the problem.)

... contd.